Financial Management Volume 1 PDF

INTRODUCTION TO FINANCIAL MANAGEMENT CHAPTER 1 INTRODUCTION TO FINANCIAL MANAGEMENT It is a well-known fact that engaging in business is like gambling, it is too risky. There are possibilities that your investments will g...

INTRODUCTION TO FINANCIAL MANAGEMENT CHAPTER 1 INTRODUCTION TO FINANCIAL MANAGEMENT It is a well-known fact that engaging in business is like gambling, it is too risky. There are possibilities that your investments will gain profits but there are also chances that you will end up losing. There is need to have enough capital in putting up a business a to be used for operations and investments. The business may be in the form of sole proprietorship, partnership or corporation. In addition, these capital or funds must be managed properly in order to attain the operating and financial objectives of the business. In a corporate form of business, there is a need to employ separate managers who will govern the business in behalf of the owners, known as shareholders. These managers, as agents, are given the power to decide on the investments, finance and operations of the corporation. In this chapter, we will introduce financial management by discussing the following: The kinds of business organization and their goals Different characteristics of these business organizations Different kinds of corporations that are acceptable and not acceptable under Philippines laws Who are the financial managers and what are their roles in the company What is agency conflict and the how such conflicts be resolved Priority between ethics and profit goals Financial Management is the process of planning, directing, organizing, controlling and monitoring of the monetary resources in order to achieve objectives and goals of the INTRODUCTION TO FINANCIAL MANAGEMENT business. The financial managers are responsible for the management of these monetary resources of the business. I. Kinds of Business Organizations: A. Sole Proprietorship is regarded as the simplest form of business organization. This is owned by an individual, known as the sole proprietor, who has the full authority in managing the assets of the business. This kind of business organization is subject to fewer government regulations as compared to partnership and corporation. Thus, the registration is only through the Department of Trade and Industry (DTI) and the business income is not subject to separate taxation. However there are disadvantages of forming a sole proprietorship. One of which is the unlimited liability of a sole proprietor. In this case, the debts and losses of the business shall be borne by the personal assets of the owner in time of bankruptcy. Another disadvantage is the limited life of the business because the death of the sole proprietor leads to termination of the proprietorship. Lastly, the amount of capital raised is significantly limited since the source of the funds of the business is limited only the sole proprietor unlike in the case of partnership and corporation. B. Partnership, as provided by the New Civil Code (NCC) of the Philippines, is a contract of two or more persons who bind themselves to contribute money, property or industry to a common fund, with the intention of dividing the profits among themselves. Two or more persons may also form a partnership for the exercise of profession. More so, the partnership has a juridical INTRODUCTION TO FINANCIAL MANAGEMENT personality separate and distinct from that of each partners (Article 1767-1768 of NCC) A partnership may be constituted in any form, whether oral or written, except where immovable property or real rights are contributed thereto, in which case a public instrument shall be necessary. In addition, the capital of Three contract of partnership having a Thousand Pesos (P3,000) or more, in money or property, is required to be: 1) In public instrument and 2) Recorded in the Office of the Securities and Exchange Commission (SEC). However, the failure to comply with the above requirements shall not affect the liability of the partnership and the members thereof to third persons. (Article 1771-1772 of NCC) Partnership may be classified as General or Limited partnership. In a general partnership, all the partners have unlimited liability like the sole proprietor, wherein creditors of the partnership may have claim® against the separate assets of the partners for payment of debt in case of bankruptcy. However in a limited partnership, there are partners known as limited partners that have liability to the creditors only up to the extent of their capital contribution, thus, their separate assets are safe from the claims of these creditors. Like Sole Proprietorship, the life of the partnership is also limited in a sense that death of one of the partners will result to the dissolution of the partnership. 5 INTRODUCTION TO FINANCIAL MANAGEMENT The following are the usual causes of dissolution of the partnership: 1. Retirement of a partner/s 2. Admission of a partner/s 3. Incorporation of partnership® 4. Death of a partner/s An advantage of partnership is that there is usually more capital raised as compared to the sole proprietorship because of larger number of source of capital. On the contrary, it has less capital compared to corporation. Moreover, it is subjected to 30% corporate income tax since the Tax Code of the Philippines does not distinguish, for tax purposes only, a partnership from corporation. C. Corporation, as provided by the Corporation Code of the Philippines (CCP), is an artificial being created by the operation of the law, having the right of succession and the powers, attributes and properties expressly authorized by law or incident to its existence. (Section 2 of CCP) This juridical entity is composed of five (5) or more natural persons, not exceeding fifteen, who are called incorporators and it must be also be registered with the Securities and Exchange Commission (SEC). Corporation is regarded as the most complex form of business organization because of its fund raising capabilities, unlimited life and being subject to stricter government regulations. The owners are referred as shareholders of the corporation who have limited liability. Hence, the claim of the corporate creditors is only up to the amount of capital investments of these shareholders and the personal assets of the latter are  INTRODUCTION TO FINANCIAL MANAGEMENT not subject to appropriations. These shareholders, unlike partners, can sell their ownership to existing shareholders or new investors without the need to secure the consent of the other shareholders. Thus, in a there is an ease of transferring ownership of the corporate form of business. However, one drawbacks of this form of business is the so called dual taxation wherein the income of the corporation is subject to corporate tax while the earnings of the owners or shareholders are subject to separate individual income tax. FIGURE 1-1: The Characteristic of Business Organizations: Characteristics of Sole Partnership Corporation Business Proprietorship Organization 1. Owner(s) are Manager Partners Shareholder called S 2. Owner and NO NO YES managers are separate 3. Owner's Unlimited Unlimited Limited** Liability NO YES* YES 4. Separate taxation 5. Life of the Limited Limited Unlimited Business *Except in General Professional Partnership (GPP), because this partnership will not be taxed like a corporation. According to Section 22(B) of the NIRC, "general professional partnerships are those formed by person for the sole purpose of exercising their common profession, no part of the income of which is derived from engaging in any trade or business. Moreover, for INTRODUCTION TO FINANCIAL MANAGEMENT tax purposes, the term "corporation" shall include partnership, no matter how created or organized, joint- stock companies, joint venture accounts (cuentas en participacion), association, or insurance companies but does not include general professional partnerships and joint venture or consortium formed for the purpose of undertaking construction projects or engaging in petroleum, coal, geothermal or other energy operations pursuant to an operating consortium agreement under service contract with the Government" Hence, as an exception GPP's income is not taxed separately using the 30% corporate income tax. *** Except when the doctrine of piercing the veil of corporate fiction applies. The said doctrine shall disregard the separate personality of the corporation because the veil of corporate fiction was used as a shield to perpetuate fraud, justify wrong, defeat public convenience or defend crime. The effect of this doctrine is to make the directors, officers and shareholders, involved in fraud or crime, liable for the obligation of the corporation. (Sundiang-Aquino Reviewer on Commercial Law, 2006 ed..pp.236-237). Types of Corporation: A. As to legal status: De Jure Corporation - this is a corporation organized in accordance with the law. There is a strict or substantial compliance with the statutory requirements for its incorporation. Hence, it exists in fact and in law. INTRODUCTION TO FINANCIAL MANAGEMENT De Facto Corporation - this is a corporation that exists only in fact but not in law because there is a flaw in its incorporation. Hence, it has no legal right to corporate existence as against the state. B. As to functions and governing law: Public Corporation - these are organized by the state for the government to promote general welfare of the public. These are governed by Special laws and the Local Government Code of the Philippines. Private Corporation - these are organized by private individuals for the purpose of generating profit. These are governed by the Law on Private Corporation. C. As to existence of stocks: Stock Corporation A corporation in which capital stock is divided into shares and is authorized to distribute to the holders thereof of such shares dividends or allotments of the surplus profits on the basis of the shares held. (Sec. 3 of the Corporation Code of the Philippines). The owners are called as shareholders or stockholders. Non-stock Corporation - A corporation which has no stocks issuances and no distribution of dividends to its members. However, a corporation is not automatically considered as a stock corporation if there is a statement of capital stock. The Supreme Court ruled that if the dividends are not supposed to be declared or there is no distribution of retained earnings, the corporation is still a non-stock corporation. Moreover, the owners are called members. (Sundiang-Aquino, Reviewer on Commercial Law 2006 ed., pp.243-246. INTRODUCTION TO FINANCIAL MANAGEMENT D. As to shares being traded in stock exchange: Publicly listed Company- this is a corporation whose shares are offered to public or traded in the Philippine stock exchange. Hence, this corporation undergoes initial public offering (IPO). Privately owned Company - this is a corporation whose shares are not traded in the stock market. Moreover, this is a corporation "going private" because it restricts the stockholders to a certain group, usually, family member. This is sometimes called a close or closely held corporation or privately held Corporation. The following corporations are not acceptable in Philippine Law: Limited Liability Company - this is a business structure which combines the tax advantage of a partnership (General Professional Partnership) and limited liability advantage of a corporation. Professional Corporation - this is composed of persons with same professions such as Doctors, Lawyers or Certified Public Accountants. Goals of the Corporation: People venture into business with the hope of gaining profits and the fear of incurring losses. It is a fact that all forms of business organizations whether sole proprietorship, partnership or corporation has the goal of maximizing earnings or profits. More so, having big 10 INTRODUCTION TO FINANCIAL MANAGEMENT profit signals good financial and operating performance of the business. Thus, profit maximization, as a measure of success of the business, may be the end goal of the sole proprietor or the partners who personally manage their business. However, for a corporate form of business, this profit maximization is just a means to an ultimate end goal of the corporation. The shareholders of the corporation will earn income from their capital investments through dividend yield and capital gains yield. The former is earned through dividend declarations approved by the board of directors (BOD) while the latter is through selling of stocks or ownership to either prospective investors or existing stockholders at a gain. This is when the stock price is higher than the cost of investment. (in depth discussion on dividend and capital gains yield will be on Chapter 7 - Stock Valuation) In connection with this, the ultimate goal of a corporation is shareholder's wealth maximization. This is sometimes referred to as stock price maximization. the increase in the value of stock price resulting to capital gains that shareholders will yield on their investments. This is one of the reasons why shareholders want the financial managers to maximize the market value of the firm and not just to maximize its profits. The market value of the firm depends on the good decision making of the financial managers regarding the company's activities such as investment, financing and operations. Moreover, the condition of the global economy, inflation rates, taxes and laws imposed upon 11 INTRODUCTION TO FINANCIAL MANAGEMENT the firm and the volatility of the stock market are factors that significantly affect the said market value. The goal of maximizing the market value of the corporation is more important than the goal of maximizing profits because of the following reasons: In maximizing the market value of the corporation, discount rate which reflects the risks of capitalization and the time value of money is taken into consideration while profit maximization does not consider such. In maximizing future profits, the company may opt to decrease and postpone its dividend declaration and instead, it will reinvest the freed up cash. If the reinvestment is too risky and will not be successful, this will be detrimental to the shareholders. Thus, shareholder's wealth is not maximized. The following are the inappropriate ways on how management maximizes the profit of the corporation: a) Management wants to accelerate sales by materially increasing the selling prices of the goods offered to the consumers, or b) Management wants to reduce expenses by cutting wage rates of the laborers or buying cheaper materials for production. These methods of maximizing profits will have a negative impact on the future earnings of the company and will result to agency conflicts. 12 INTRODUCTION TO FINANCIAL MANAGEMENT Stock price or market value per share considers both cash flows for the current and future years. Profit on the other hand, may refer to either current year's profit or future year's profit. If the goal is profit maximization, the question is which year's profit are we referring to? For example, the company may maximize current year's profit by decreasing advertising and promotion cost. However, this may decrease the future years' profit because sales of new products in the future may be decreased by these costs cutting done in the current year. The profit computation varies depending on the purpose. Thus, there are differences in the computation of profit for tax purposes and profit for accounting purposes. IV. Financial Managers of the Corporation: Financial managers are employees who are responsible for managing the monetary resources of the corporation in order to maximize firm's value. They are also responsible for dealing with the different financial markets such as stock market or bond market; and with financial institutions like banks. These managers, who are the agents of the shareholders (owners), are given the authority to perform investment, financing and operating decisions that will benefit the corporation. Generally, the Financial Managers are: Board of Directors (B.O.D.) - They are direct owners and are elected by the shareholders to manage the corporation. They are charged with ultimate 13 INTRODUCTION TO FINANCIAL MANAGEMENT governance of the corporation. Thus, they have the ultimate responsibility for deciding on highly important financial matters of the corporation. Moreover, BOD decides on when to declare and how much dividends per share to distribute. Chief Financial Officer (C.F.O) - also known as the Vice President for Finance (VP-Finance), who has responsibility over financial planning and formulation of financial corporate strategies. Under his supervision are the Treasurer and the Controller. Treasurer - one who focuses on the financial aspect of the corporation; wherein he has the responsibility on raising and managing the capital or funds of the company. Moreover, he is responsible for transacting and maintaining good relationship with various banks; and the formulation of the company's credit policies and collection. Controller - One who focuses on the accounting and budgeting aspect of the corporation; he is responsible for the custody of financial records, preparation of the financial statements, and interpretation of financial data. Moreover, he is responsible for the management of the budget for the efficient usage of funds.' 14  INTRODUCTION TO FINANCIAL MANAGEMENT FIGURE 1-2: To present the line of authority of these financial managers, the organizational structure of the firm is shown below: BOARD of DIRECTORS VP- Audit Chief Executive Officer (CEO) VP-Manufacturing Chief Financial Officer (VP- Finance) VP - Sales Treasurer Controller V. General Role of Financial Manager: It is noted previously that financial managers are responsible for managing the monetary resources of the corporation. Managing these resources means how much fund should be invested in the acquisition of real assets, how much fund shall be retained and plowed back to the corporation or how much shall be paid out as dividends to the shareholders. Moreover, it is the responsibility of these financial managers to raise additional capital or funds to support the investments and operations of the corporation. Therefore, the financial managers shall perform these roles which are geared towards the attainment of the ultimate goal of the corporation: 15 INTRODUCTION TO FINANCIAL MANAGEMENT Investing Decision The investments made by these financial managers should provide benefit to the corporation in the future. This should be the main consideration of the managers when investing in tangible assets such as machineries, land or building; investments in financial assets or investing in the intangible assets such as patent, trademarks or copyright. Thus, investing decision, also known as capital budgeting, answers the question: 'what assets should the corporation acquire in order to provide better returns in the future'. In addition, the amount or percentage return as well as the period when to realize the said return, are important factors in deciding whether to accept or reject the investment. Financing Decision There are many investment opportunities that financial managers may encounter as they manage the monetary resources of the corporation. However, one of the main constraints of these managers is the scarcity of available capital. This normally results to forgone investment opportunities. Hence, in order to finance these investments the financial managers should raise capital or money through its financing activities. Generally, the financial managers accumulate funds through the following means: 1.) Performing long term financing through bank loans if the prevailing interest rate is not high; or 2.) Issuance of financial assets such as share of stocks (equity security) or bonds (debt security). 16 INTRODUCTION TO FINANCIAL MANAGEMENT In issuing share of stocks, the company accumulates fund through selling certificates of ownership of the corporation to the prospective investors or existing shareholders. The cash received from these investors will form part of the capital of the corporation and in return, the latter will distribute profits to the shareholders through dividend payments. On the contrary, the issuance of bonds to the investors known as bondholders does not indicate selling of ownership but rather signifies borrowing of funds. These bondholders are not owners but creditors of the corporation who receive interest payment instead of dividends. Hence, financing decision answers the question: "how to raise funds in order to finance the investments and operating activities of the firm. Operating Decision - In order to support the daily transactions or operations of the corporation, these financial managers should decide on how much funds should be allocated to each of its operating units. Funds raised through financing decision are not only used for the acquisition of real assets or long term investments but also for operating expenses of the corporations. These are payments for the salaries and wages of the employees, overhead costs, acquisition of materials used for production and etc. Hence, operating decision answers the question: 'how much funds will be allocated to support the day to day transactions of the firm. 17 INTRODUCTION TO FINANCIAL MANAGEMENT VI. Resolution of Agency Problem: the principal Agency conflicts are problems between and agent of the company. The conflicts arise when the financial managers (agents) prioritize their own personal interest rather than the best interest of the shareholders of the company (principal). The existence of these agency conflicts is detrimental on the part of the shareholders. Thus, the following are solutions to mitigate if not to eliminate conflicts between the managers and the stockholders: Compensation Plans - the compensation plans may differ among the companies depending on its capacity in terms of finances. As part of its compensation plan, the companies would offer incentives to their managers such as additional bonuses, percentage interest in net income of the company and stock options. These are on top of the annual basic salary of the managers. These incentives are provided in order to motivate these managers to perform better so that the goal of maximizing the value of the firm may be achieved. Say for instance, in comparing the compensation plan of the Chief Executive Officers (CEO) of the two companies: X and Y. If the CEO of Company X is given an additional incentive of 5% of the net income above the normal profitability of the corporation aside from his basic salary while the CEO of Company Y is only provided with annual salary of similar amount, we can assume that the former is more driven to improve his performance than that of the latter. 18 INTRODUCTION TO FINANCIAL MANAGEMENT However, these compensation plans sometimes provide pressure to the managers wherein it results to the commission of fraud. Say for example, if the CEO of Company X prioritizes his personal interest and wants to gain additional incentives, he can manipulate or window dress the statement of comprehensive income. Therefore, these compensation plans, if not taken appropriately, shall motivate the managers to commit fraud instead of maximizing the value of the firm. Threats as to change in Board of Directors - these Board of Directors (BOD) who are responsible for the ultimate governance of the corporation are elected by the shareholders. They are considered as passive participants because most of them would only participate during board meeting and not during business day of the company. Having a position in the board is not a permanent. The shareholders have the power to elect new set of BOD if they are not satisfied with the performance of the board particularly on how they manage the business. Threatening the members of the BOD may motivate them to become active in governing the corporation. Threats as to Management Takeover ~ the top level managers who are responsible for the daily governance of the corporation are merely appointees of the Board of Directors (BOD). These managers are employees of the corporation wherein they can be terminated or replaced if they fail to deliver what is due to the corporation. Management takeover indicates that the old management team is replaced by the new management. Threatening the old management may 19 INTRODUCTION TO FINANCIAL MANAGEMENT motivate them to improve their poor performance and drive them to manage the business well. Legal and Regulatory requirements these requirements imposed upon the corporation, especially those publicly listed companies, aim to provide security on the part of the shareholders or investors. Say for example, one of the regulatory requirements of the Securities and Exchange Commissions (SEC) upon the publicly listed corporations is to file an annual audited Financial Statements. In auditing the Financial Statements (FS), the external auditors gather substantial and appropriate data to support the claims of the management as regards the presentation of the said Financial Statement. Then, the external auditors will provide an opinion, qualified or unqualified, regarding the said financial statement. This requirement assures that the financial statements prepared by the management are reliable and that there is no material misstatements done. Therefore, this will prevent the management from committing acts that are against the interest of the owners such as fraud. Specialist Monitoring - It is assumed that employees will perform their functions well if they are monitored by their superior. However, monitoring of performance is not solely within the corporation because the external parties such as investors or creditors may also examine the performance of the company. Say for example, the corporation is in need of funds and the financial managers opt to apply for a loan in a bank. Before the application for a loan is granted, the bank shall initially examine the capacity of the debtor to pay 20 INTRODUCTION TO FINANCIAL MANAGEMENT its debt. Hence, if the bank lends money to the corporation, this signifies a healthy financial condition of the company. Conflicts between Stockholders and Bondholders: Aside from the conflicts between financial managers and stockholders, there are also conflicts between the two sources of funds. The stockholders and bondholders are investors of the firm's equity and debt securities respectively. As regards their conflict, the stockholders, as owners of the firm, want the financial managers to invest in risky investments while the bondholders, as lenders of the firm, oppose to risky investments. It should be noted that bondholders have fixed income from interest payments of the firm while the stockholder's income depends on the dividend yield and capital gains yield. The former is more concerned on the capacity of the firm to pay interest irrespective of the result of the firm's operations and investments while the latter is concerned on the dividend payments which is usually dependent on the results of the firm's operations and investments. Say for example, if the financial managers of the firm have the option to invest its P 100 Million in the following unit investment trust funds (UITF): a. 100% equity fund (High Risk) b. 50% equity or 50% debt (balanced fund) C. 100% debt fund (Low Risk) Normally, the stockholders, as risk takers, would want the P100 Million to be invested in 100% equity fund because the said fund has the highest risk which will 21 INTRODUCTION TO FINANCIAL MANAGEMENT provide the highest return. Hence, if the result of investments is positive, the firm will gain high returns which shows that the expected dividends to be distributed is also high. On the other hand, the bondholders want the managers to invest the P100 Million in lower risk investment such as the 100% debt fund or the balanced fund which provides a lower return. For bondholders, they are already assured of the fixed interest income as long as the firm is solvent. Thus, they want the managers to choose a low risk investment in order to avoid high losses and still maintain its solvency. In determining the optimal capital structure, we will learn that the firm may be classified as unlevered (without debt) and levered (with debt). More so, the additional issuances of debt securities in order to accumulate more funds make the firm more risky. In connection with this, another conflict between and stockholders may arise. The Bondholders, as risk averse investor, would protect their interest by entering into a bond covenant restricting the firm from issuing additional debt securities. In addition, they would opt to raise funds through additional stock issuances in lieu of additional debt. On the other hand, the stockholders, as risk takers, would approve the manager's decision to increase debt securities rather than stock issuances because the latter may dilute their stock ownership. (Brigham-Houston Fundamental of Financial Management, 13th ed.) 22 INTRODUCTION TO FINANCIAL MANAGEMENT Ethical Considerations: It is true that the ultimate goal of the corporation is maximizing the firm's market value or the maximization of the shareholder's wealth. This goal should be achieved not through fraudulent acts but in an ethical manner of doing business. Moreover, the company should maintain its Corporate Social Responsibility (CSR) at all times such as avoiding things that has adverse effects in the society and to the people. Ethics and the goal of maximizing shareholder wealth generally lean towards similar ends because ethical behavior builds good reputation that will benefit the organization in the long run. However, in case of conflict between ethics and profit goals, the former shall prevail because unethical dealings will provide results that taint the goodwill of the company. Say for example in the United States, the WorldCom bankruptcy in 2002 was marked as one of the top business scandals wherein the management led by CEO Bernie Ebbers fraudulently inflated assets by $11 billion and overstated the income of the company by $3.8 billion. The material misstatement is due to the failure of the management to report such amount as operating expenses. Moreover, WorldCom first reported the said amount as capital expenditures rather than operating expenses. It evident that the management of the is company window dressed the financial statements by presenting a good financial performance but in fact the business is already bankrupt. Due to this business scandal, US Congress passed the so called Sarbanes- Oxley Act which set a more stringent business regulation. 23 INTRODUCTION TO FINANCIAL MANAGEMENT In the Philippines, there are lots of business scandals which must be addressed by the government. One of which is the Globe Asiatique Fund Scam mastermind allegedly by Mr. Delfin Lee. In this scandal, a developer, with good track record like Delfin Lee, was allowed by Pag-ibig to process the loan application of their buyers, then will forward to Pag-ibig for the release the funds, thereby making the process faster. However, it turned out that 60% of the P7 billion Pag-ibig funds for housing were lent to the fictitious borrowers processed fraudulently by Globe Asiatique. Now, irrespective of the reasons the management have in doing such, may it be a move to save the company from bankruptcy, they still committed a fraudulent and unethical act. Therefore, the end no matter how noble, does not justify the means. (opinion.inquirer.net/how--globe-asiatique-scam-was- done by: Neal H. Cruz, March 19, 2014) 24 INTRODUCTION TO FINANCIAL MANAGEMENT CHAPTER EXERCISES NAME SCORE: SECTION: DATE: TRUE or FALSE: Write X if the statement is true while M if false. 1. Financial Accounting is the process of planning, directing, organizing, controlling and monitoring the monetary resources of the company in order to achieve its objectives or goals. 2. The ultimate goal of the corporation is maximizing its market value which is the same as shareholder's wealth maximization. Profit maximization does not consider the discount rate which reflects the risks of capitalization and the time value of money unlike market value maximization. 4. Profit maximization and cost minimization are goals of any business organization. 5. Profit maximization is the primary goal of all business organization. b. Shareholder's wealth maximization may be obtained through increase in amounts of dividends declared and decrease of company's stock price. 7. The roles of financial managers are to decide on its investing, financing and operating activities. 8. The treasurer's responsibility mainly focuses on the accounting and budgeting processes. 9. The controller's responsibility is to raise adequate funds and maintain control of such funds for the company. 25 INTRODUCTION TO FINANCIAL MANAGEMENT 10. The Chief Financial Officer is also known as the Vice President of Finance Department who supervises the treasurer not the controller. 11. The board of directors is considered owners who are responsible for the overall governance of the corporation. 12. Board of directors decides on highly significant financial matters of the firm while controller is responsible in the capital budgeting aspect of the firm. 13. The external auditor not the controller has the ultimate responsibility in preparing the financial statement of the firm since they will provide an opinion whether qualified or unqualified. 14. Funds raised through financing decision are not only used for investments but also for the funding of the operating expenses of the corporations. 15. In investing decision, the financial manager answers the question how much fund must be raised in order to finance the investing activities. 16. The financial managers decide on the operating activities of the firm wherein they allocate funds for the acquisition of non- current assets or real assets. 17. Financing activities focuses on fund raising, an example of which is through issuance of corporate bonds (equity security) or share of stocks (debt security). 18. The acquisition of raw materials and equipment is an example of investing and operating activity, respectively. 19. The sole proprietorship business is subject to lesser regulations as compared to the Corporation as a business. 26  INTRODUCTION TO FINANCIAL MANAGEMENT 20. The amount of capital of the corporation is usually smaller than that of the partnership as a business. 21. The Corporation is a legal entity created by the state and is a direct extension of the legal status of its owners and managers, that is, the owners and managers are the corporation. 22. De Facto Corporation is a corporation that exists in fact and in law because there is no flaw in its incorporation. 23. Even if there is statement of capital stock but the dividends are not supposed to be declared, the corporation is still a non-stock corporation. 24. Closed or Private Corporation, Public Corporation and Professional Corporation are accepted in the Philippines. 25. The partnership form of organization has easy transferability of ownership as opposed to corporation. 26. One disadvantage of forming a corporation is that shareholders have limited liability. 27. Partnership must be registered in the Department of Trade and Industry (DTI) rather than Securities and Exchange Commission (SEC). 28. The liability of a sole proprietor is unlimited while the shareholder's liability is limited only up to the amount of investment in stocks. 29. The limited liability characteristic of owners of the corporation is subject to an exception called the doctrine of piercing the veil of corporate fiction. 30. The life of the corporation is limited only up to 50 years while the life of a partnership business is unlimited since the original 27 INTRODUCTION TO FINANCIAL MANAGEMENT partners may transfer their ownership to their heirs through succession. 31. The actions that maximize a firm's stock price are inconsistent with maximizing social welfare. 32. Limited Liability Company (LLC) is a new type of organization that is hybrid between a partnership and a corporation. This provides that they are taxed and has a limited liability like a corporation. 33. The Limited Liability Company is not accepted in the Philippines while the Limited Partnership is acceptable in the Philippines. 34. Publicly listed company is a corporation whose shares are traded in the Philippine stock exchange while privately owned company's shares are not offered to the public. 35. Professional corporation, like General professional partnership, is composed of professionals and is acceptable business organization in the Philippines. 36. Financial Managers are agents of the Shareholders, the latter being the real owners of the corporation are principals. 37. If these agents do not prioritize the interest of the principal owners rather their own interest, agency conflicts may exist. 38. Compensating managers with stock can reduce the agency problem between stockholders and managers. 39. Paying these managers with large fixed salaries rather than increasing the threat as to takeover can mitigate the agency conflicts between stockholders and managers. 28  INTRODUCTION TO FINANCIAL MANAGEMENT 40. Threatening the old management may motivate them to rectify their poor performance and drive them to manage the business well. 41. There is a conflict between stockholders and bondholder wherein the former wants the management to take risky investments while the latter wants the less risky investments. 42. Bondholders are providers of funds since they invested in the debt security issued by the firm, hence they are also deemed as owners of the firm. 43. Good reputation may be attained through ethical business practices and is considered as the best advertisement. 44. The firm should always consider their corporate social responsibility in doing business. 45. Unethical behavior will eventually lead to failure of achieving the organizations goals as mirrored by the results of this behavior on Enron and WorldCom. 46. Ethics and the goal of maximizing shareholder wealth generally lean towards of opposite ends since managers of an organization would not profit from ethical behavior. 47. If there are conflict between profit maximization and ethical consideration, the latter must prevail. 48. If there are conflict between shareholder's wealth maximization and ethical consideration, the former should prevail. 49. One of the ways to minimize losses is to window dress the financial statement in order to make it more attractive to prospective investors. 29  INTRODUCTION TO FINANCIAL MANAGEMENT 50. The management in order to save the firm from bankruptcy may perform unethical conduct since the end if it is with noble intention may justify the means. 51. By allowing a culture of leniency towards any action, both legal or otherwise, the organization greatly allows itself to profit in the long-run thereby able to maximize shareholder wealth in the process. 52. There is a very small amount of incentive in maintaining ethical behavior in an organization. 53. Unethical behavior will eventually lead to failure of achieving the organizations goals as mirrored by the results of this behavior on Enron and WorldCom. 54. An entity wishing to ensure its selection as a government contractor should ensure that government officials receive sumptuous gifts. The benefits of being selected as a government contractor far exceeds the cost of the gifts provided and justifies the action undertaken since it will all inure to the benefit of the shareholders. 55. The primary goal of a publicly-owned firm interested in serving its stockholders should be to maximize expected EPS. 56. Restrictive covenants in debt agreements are an effective way to reduce agency conflicts between stockholders and managers. 57. Managers generally welcome hostile takeovers since they often increase the company's stock price. 58. One disadvantage of forming a corporation is that your shareholders have limited liability. 59. Relative to sole proprietorships, corporations generally face more regulations, but find it easier to raise capital. 30 INTRODUCTION TO FINANCIAL MANAGEMENT 60. Bondholders generally want managers to select risky projects, but shareholders prefer that managers select safe projects. 61. Since they are guaranteed a certain set of cash flows, corporate bondholders generally want corporate managers to select high risk/high return projects. 62. The actions that maximize a firm's stock price are inconsistent with maximizing social welfare. 63. The concepts of social responsibility and ethical responsibility on the part of corporations are completely different and neither is relevant in maximizing stock price. 64. One of the ways in which firms can mitigate or reduce agency problems between bondholders and stockholders is by increasing the amount of debt in the capital structure. 65. The threat of takeover is way in which the agency problem one between stockholders and managers can be alleviated. 66. Managerial compensation can be structured to reduce agency problems between stockholders and managers. 67. The threat of a takeover can reduce the agency problem between bondholders and stockholders. 68. Closed/Private Corporation, Public Corporation and Professional Corporation are accepted in the Philippines. 69. In part due to limited liability and ease of ownership transfer, corporations have less trouble raising money in financial markets than other organizational forms. 70. The ultimate goal of a publicly-owned firm interested in serving its stockholders should be to increase profits and decrease costs. "THAT IN ALL THINGS, GOD MAY BE GLORIFIED" 31  FINANCIAL ENVIRONMENT CHAPTER 2 FINANCIAL ENVIRONMENT In chapter 1, we have learned that the ultimate goal of the corporation is maximization of its market value or shareholder's wealth maximization. One of the means to achieve this primary goal is to maximize profits through proper allocation of funds to its operating and investing activities. However, there are times when firm's capital is not sufficient to support its investments and operational activities wherein there is a need toraise additional funds through the utilization of financial markets, financial institutions or stockholders infusing additional capital. Companies under financial distress may engage in the issuance of its financial assets (debt and equity securities) in the financial markets or borrow money from the financial institutions. In this chapter, we will learn financial environments by discuss the following: The different kinds of markets The different financial intermediaries The transfer of financial assets Direct and Indirect transfer Stock market transactions Stock market efficiency Financial environments are factors and situations that primarily affect the financial aspects of the corporation. The principal factors are the sources of financing through A) Financial Markets and B) Financial Intermediaries. The main source of funds used for investments and operations come from the savings of the investors. The financial managers acquire these funds through equity financing and debt financing. These financing transactions take place in the so 35  FINANCIAL ENVIRONMENT called financial markets and with the intervention of the different financial intermediaries and institution. On the other hand, there are other markets not classified as financial markets but can affect the operating and investing activities of the firm. I. Different types of markets A. Financial Markets are the place where financial assets such as Equity Securities (shares of Stock) and Debt Securities (Bond certificates) are issued and traded. 1. Stock Market - this is a market where equity securities are being issued and traded. In this market, the stockholders may sell their stock investments or the firm may issue additional stocks if the stock price is overvalued or may purchase stocks if undervalued. For example, if the firm has to raise funds but wants to avoid high interest rate, the firm may issue equity securities in this market. 2. Bond Market - this is a market where debt securities are being issued and traded. This is also referred as the fixed-income market because the investors or so called bondholders receive fixed interest payments from their investments assuming they will hold the bond until maturity or on a longer period of time. For example, if the firm has to raise funds but the stock price is undervalued, the firm may issue debt securities rather equity securities in this market. 36  FINANCIAL ENVIRONMENT 3. Money Market - this is a market where short-term debts with maturities of one year or less are used as a source of financing. An example of this short-term debt security is a Treasury bill which is issued by the government with maturity of one year or less. 4. Capital Market - this is a market where long-term debt and equity securities are involved, for financing. The examples of the long-term debt security are Treasury note and Treasury bond wherein the former is a debt security issued by the government usually with maturity of more than one year but not more than 10 years while the latter is a debt security issued by the government with maturity of more than 10 years. B. Other markets: 1. Physical Market is also known as real asset or tangible markets because the products involved are real estate, property plant and equipment, inventories, etc. Hence, those assets not qualified as financial assets are sold in this market. Say for example, the acquisition of raw materials to be used for the manufacture of products takes place in this market. In addition, if the firm has to expand its operations and increase its production, the firm has to purchase machineries in this market. 2. Spot Market - this is a market where assets or goods are sold for and delivered on the spot or today. Thus, the 37  FINANCIAL ENVIRONMENT determination of price and delivery of goods is on the same date. An example is when a rice dealer went to the farm during harvest to purchase all the harvest at an agreed price and to be delivered on the same day; this takes place in spot market. Another example is when a Philippine based corporation purchased inventories on February 14, 2017 from a US based corporation to be imported and paid on March 3, 2018, the Philippine corporation has to pay in US dollars. This is an example of an exposed liability position (ELP) where the amount of accounts payable changes as the exchange rate changes. Therefore, there is a need to purchase foreign currency to settle the accounts payable. The purchase of foreign currency will be on the settlement date, March 3, 2018. Thus, the determination of exchange rate (price) and delivery of investment in foreign currency (US dollars) is on the spot. 3. Future Market - this is a market where future contracts are sold. A future contract is a contract that gives the purchaser an obligation to buy an asset (and the seller an obligation to trade an asset) at a predetermined price at a future date. Thus, the price is agreed today but the delivery of goods is in the future. An example is when a rice dealer went to the farm a month before harvest to purchase all the future harvest at an agreed price today and to be delivered on the day of harvest; this takes place in future market. 38  FINANCIAL ENVIRONMENT Another example, is investing in a 1.) forward contract or 2.) option contract (both hedge instruments) to hedge foreign currency transaction (hedge item). In a forward contract, the exchange rate used to value the purchase or sale of foreign currency is a forward rate. Hence, the forward rate (price) is already determined today but the delivery of the investment in foreign currency (ex. US Dollars -$) is in the future. An option contract is an example of a derivative whose value is derived from the price of an "underlying" asset. Option contracts are classified as call option (option to buy) or put option (option to sell). This contract has an option price set at the inception of the transaction which is exercisable by the investor in the future, hence making the transaction under future market. 4. Private Market - this is a market where negotiation and agreement takes place personally between two parties. Hence, making the contract unique or tailor-made. Say for example, investing in a life insurance is personal between the insured and insurer. The policy holder being the insured while insurance company being the insurer. Another example of transaction that takes place in a private market is when a depositor opens a savings or checking account in a bank. 5. Public Market - this is a market where a security or contracts with standardized features are being traded and held by individuals. 39  FINANCIAL ENVIRONMENT For example, in stock markets and bond markets, the securities (stock certificates and bond certificates) issued by the corporation have standard features. Hence, making them available for trading or exchange unlike the life insurance policy discussed above. Financial Intermediaries: Financial Intermediaries are the organizations that provide financing to the individuals, corporation or other organizations by raising funds or money from: investors. 1. Mutual Funds (MF) - the investment company pools money from the investors then invests these accumulated amount in a portfolio of securities whether equity (shares of stock), debt (bonds) or money market (short term securities). In Mutual Fund, the investors purchased shares of the investment company thereby giving the former the right to receive dividends. The body that regulates these mutual funds is the Securities and Exchange Commission. An example of mutual fund is Sun Life Balanced Fund, Philequity Peso Bond Fund or ALFM Growth Fund. (philpad.com/best-mutual-funds- in-the-philippines-2015) 2. Unit Investment Trust Fund (UITF) the investment company sells units of investment to the investors to accumulate a trust fund. The trust fund may be invested also in equity, debt or balance of equity and debt. Hence, the investors own units of investments not shares of stock. The regulatory body which supervises these unit investment trust funds is the Banko Sentral ng Pilipinas. An example of investment in UITF is the BPI Equity Index 40  FINANCIAL ENVIRONMENT Fund of the Bank of Philippine Island. the (philpad.com/mutual-fund-vs-uitt-similarities-and- differences-advantages-and-disadvantages) 3. Pension Fund - these are pooled contribution from the employees or from the employers that serves as the investment plans for the retirement benefits of the employees. The accumulated funds may be invested in shares of stocks or in a mutual fund in order to increase the amount of pensions received by the retirees. 4. Financial institution this is a kind of financial intermediary that provide additional financial services other than pooling and investing of funds. One type of financial institution is a bank which may serve as debtor and creditor at the same time by accepting cash deposits from savers (borrowing) and providing loans to individual or to other firms (lending). Another type of financial institution is the insurance company that sells protection against the losses from fortuitous events like fire, accidents and death. Transfer of Securities: Direct Transfer In a direct transfer of securities, the equity securities evidenced by stock certificates and debt securities evidenced by bond certificates are issued directly to the investors. In turn, these investors pay directly to the issuing company. Thus, the securities do not pass through the possession of any financial intermediaries. 41 FINANCIAL ENVIRONMENT Indirect Transfer: In an indirect transfer of securities, the issuing company seeks the aid of the financial institution to easily issue their securities to the investors, thus there is mediation between the issuer and the investor. Moreover, the investor may acquire securities from the intermediary that are different from what have been issued by the corporation. Therefore, indirect transfers of securities are classified as: Indirect transfer through Investment Bank the securities of the company are bought by the investment bank or the SO called underwriter with the intention of reselling them to a prospective investor. The securities of the issuing company will be in the hands of the investors. Thus, no new form of capital is created. Indirect transfer through Financial Intermediary the securities of the company are bought by these financial intermediaries without the intention of reselling the said securities; rather they will sell their own securities to the new investors. The securities of the issuing company are in the possession of the financial intermediaries while the new investors will get the securities issued by the financial intermediaries e.g. Investors will receive the insurance policies issued by the Insurance Companies. Thus, new form of capital is created. 42  FINANCIAL ENVIRONMENT IV. Stock Market Transaction: Stock Markets are markets where shares of stocks of corporation are sold to new investors and or existing stockholders. The Philippines had two stock markets, namely: 1.) Manila Stock Exchange (MSE) which was established on August 8, 1927; and 2.). Makati Stock Exchange (MkSE), which was established on May 27, 1963. However, these two markets were unified forming the Philippine Stock Exchange on December 23, 1992 with eight (8) constituent indices such as: PSE Composite Index (PSEi) PSE All shares Index (ALL) PSE Holding Firms Index (HDG) PSE Industrial Index (IND) note → PSE Financial Index (FIN) PSE Mining and Oil Index (M-0) PSE Property Index (PRO) PSE Services Index (SVC) The figure below illustrates the stock position of portfolio investments with the performance of the abovementioned indices. 43  FINANCIAL ENVIRONMENT Figure 2-1: The Stock Market Index and Stock Position of investments MARKET INDEX ACCOUNT BALANCES CASH 4,526.20 ALI 3,970.47 +18.15 6,966.18 67 FIN 1.547.59 +12.37 MARGIN/CREDIT 0.00 92 6.584.67 +73.57 BUYING POWER 4,526.20 +55.84 (+0.81%) IND 10.930.58 20.85 10.199.94 -3413 YIEW PORTFOLIO TURNOVER 4.59B 203 PRO 2.988.77 +25.69 1,513.77 +8.32 VIEW ORDERS STOCK POSITION BUY / SELL CODE LAST DIFF BID VOLUME BID PRICE ASK PRICE ASK VOLUME BUY SELL 85.75.69 470 83.70 85.75 490,040 BUY I SELL 18.50 0.3400 87 46,700 18.50 18.88 5,300 SELL 6.94 0.0400 0.57 947,400 6.94 6.95 80,000 BUY I SELL 51.40 3.63 2,000 50.00 51.40 7,900 BUY ] SELL 46.50 -0.2000 0.4283 15,300 46.50 47.00 7,500 BUY [ SELL 2052.00 30.00 1.48 50 2,044.00 2,052.00 8,400 (SOURCE: www.bpitrade.com) This figure shows that the investor has invested in the stocks of the following company as shown in the CODE column: Bank of the Philippine Island (BPI) East West Bank (EW) Petron Corporation (PCOR) Philippine National Bank (PNB) San Miguel Corporation (SMC) Philippine Long Distance and Telephone Company (TEL) The LAST column shows the current stock price while the DIFF column is the peso value increase or decrease in the said price of these stocks. The BID VOLUME column displays the number of outstanding stocks that the willing buyers want to buy while the ASK VOLUME column is the number of outstanding stocks that willing sellers want to sell. The BID PRICE column illustrates the stock prices that buyers are willing to pay while the ASK PRICE column is the stock prices that sellers are willing to accept. Say for example, in BPI stock, the BID price is P 83.70 while the 44  FINANCIAL ENVIRONMENT ASK price is P 85.75. There will be a bargain between the willing buyer and seller until they meet at an agreed price. Now, if the BID equals to ASK price, say for example at agreed price of P84.50, this will be new current market price of the stock to be shown in the LAST column. The following are the stock market transaction: 1. Initial Public Offering (IPO) Markets are markets where the stocks of a closely held corporation, going public, are offered to the = public for the first time. The closely held corporations undergo IPO in order to raise additional capital to finance their operating and investing activities. To aid these corporations in going public, the investment banker may purchase all the new offered shares at underwriter's price then sell them to public at a retail price. Hence, this is in the form of indirect transfer through investment bank. However, the corporation may also undergo IPO through direct transfer where individual investors may place their respective bid prices and the corporation selling directly to them. Generally, the IPO transaction is classified as primary market transaction since the new stocks were sold to the public, who are new shareholders. An exception is when the outstanding stocks of the corporation owned by the existing shareholders were sold to the public, the IPO transaction is under a secondary market transaction. 45  FINANCIAL ENVIRONMENT 2. Seasoned Offering is the issuance of additional shares of stocks of the company after its first time offering in order to finance the capital budget or to improve its capital structure. This kind offering may be done by family corporations or publicly listed corporations. 3. Primary Markets - are involved with the issuance or selling of new shares of stocks to the investors through the aid of the investment bankers. The cash proceed from primary market transaction goes to the corporation. Thus, the transactions in this market change the size of the capital structure of the company. 4. Secondary Market - are involved with the sale of the outstanding shares of stocks to the existing shareholders or to new investors. The cash proceed from secondary market transaction goes to the selling shareholders, not the corporation. Thus, the capital structure of the company is not affected by the secondary market transactions. To illustrate the stock market transactions: In January 2, 2018, TRIPLE B CONSTRUCTION, a family corporation engaged in construction business, wants to raise additional fund in order to finance their additional capital expenditure. To address their financial needs, the board of directors decided to have the corporation listed in the Philippine Stock Exchange (PSE) so that they can sell new stocks to the public. On February 1, 2018, TRIPLE B CONSTRUCTION 46  FINANCIAL ENVIRONMENT sold its shares to the public for the first time. The outstanding and authorized capital stocks of the corporation are 500,000 and 1,000,000 shares respectively. In June 30, 2018 the TRIPLE B CONSTRUCTION, now a publicly listed company, sold additional 250,000 shares to fund their expansion projects. Hence, the outstanding shares as of this date are 750,000. One of the stockholders, named Don Bernabe, owned 200,000 shares. He sold half of his ownership to his brother Mr. Jeffries on October 30, 2018. On the other hand, TRIPLE B CONSTRUCTION repurchased the remaining 100,000 shares of Don Bernabe On November 30, 2018. Analysis of the transactions: The Initial Public Offering (IPO) was performed on February 1, 2018. The Seasoned Offering (SO) was after the IPO, in this illustration, it was done on June 30, 2018 when additional 250,000 shares were sold. The IPO and SO are considered as sale of shares under primary market transaction. The sale of outstanding shares by Don Bernabe to Mr. Jeffries on October 30, 2018 is a secondary market transaction since the capital structure of the firm is not affected. 47  FINANCIAL ENVIRONMENT The stock repurchase by TRIPLE B CONSTRUCTION from Don Bernabe on November 30, 2018 is considered as primary market transaction because such purchase affected the capital structure of the firm. Stock Market Efficiency: Stock market may be considered as efficient or inefficient market. If the stocks market shows that the market prices of the stocks are about equal or close to intrinsic values, there is market efficiency. In this situation, the stock price reflects all publicly available information hence, are fairly priced. Thus, Investors returns or losses under efficient market are relatively low. On the other hand, if the stock market is inefficient, the stock prices are considered to be highly overvalued or undervalued. Hence, the investors are not confident to invest unless they knew some information over the others. There are three levels of efficiency in Efficient Market Hypothesis (EMH) namely: Weak form this level shows that the information regarding past or historical prices of a particular stock is not conclusive in predicting stock prices. Hence, an investor cannot beat the market by simply analyzing the past performances of the stock. Semi-strong form this level shows that all the available public information is already 48  FINANCIAL ENVIRONMENT incorporated in the stock prices. Hence, the investors cannot beat the market solely by analyzing the published financial reports of the company unless they have information from company insiders. Strong form this level show that investors cannot beat the market even with insider information. Hence, the investors in this efficient market cannot earn high returns. The stock prices can be classified as: a) Market value - also known as perceived value, is the price of the stock which is currently traded in the market. In the Philippines, the market prices of the stocks of publicly listed companies are readily available in the Philippine Stock Exchange (PSE). b) Intrinsic value this is the true value of the stock. This is the price that the willing buyer will bid and willing seller will ask provided that all necessary information about the stock is available. The intrinsic value can be estimated using either the a) Dividend Discount Model or b) Corporate Valuation Model. (In depth discussion regarding these models will be on Chapter 7 - Stock Valuation.) If the so called market value (perceived value) is equal to the intrinsic value (true value), the stock price is at equilibrium. Hence, the investor is neutral as to selling or buying stocks. 49 FINANCIAL ENVIRONMENT If the market value of the stock is higher than the intrinsic value, the stock price is deemed as overvalued. Thus, the stockholders are expected to sell than to buy shares. If the market value is lower than the intrinsic value, the stock price is undervalued. Hence, the investors are expected to purchase more shares to take advantage of lower price. (Brigham- Houston, Fundamentals of FINANCIAL MANAGEMENT 13th ed, page 46-49) 50  FINANCIAL ENVIRONMENT CHAPTER EXERCISES NAME SCORE: SECTION:_ DATE: TRUE or FALSE: Write X if the statement is true while M if false. 1. Financial environments are factors and situations that primarily affect the operating aspects of the corporation. 2. Financial Markets are where physical assets such as stocks and bonds are issued and traded. 3. The firm may increase funds through the sale of equity security or issuance of debt security in capital market. 4. The real asset or tangible markets are where financial assets are sold or traded. 5. In a private market, the contracts between two persons are with standardized feature making it available for trade. 6. An example of transaction in a private market is when an investor signs a contract of deposit with a bank, while trading of stocks is an example transaction in public market. 7. Public Market is market where a security or contracts with tailor-made features are being traded and held by individuals. financial market in which funds are borrowed 8. Money Market is a or loaned for short periods. Capital Markets involve instruments with maturities of longer than one year. 10. In a secondary market the outstanding shares are sold by a shareholder to an investor thereby increasing the capital structure of the corporation. 51  FINANCIAL ENVIRONMENT 11. If the goods are to be delivered in the future and the price is determined today, it is a spot market transaction. 12. Treasury bonds are long term debt securities issued by the corporation which provides for a fixed interest income for more than 10 years. 13. Treasury bills are debts of the government with more than 10 years of maturity. 14. Mutual Funds are pooled contribution from the employees or from the employers that serves as the investment plans for the retirement benefits of the employees. 15. Spot Market is a market where assets or goods are delivered today and the price of the said assets is determined today. 16. An example of spot market transaction is buying of foreign currency using the forward rate. 17. A derivative is a contract whose value depends on the value of an underlying asset. 18. Option contracts are transacted in the future market because contract has an option price set at the inception of the transaction which is exercisable by the investor in the future. 19. Call option contract gives the investor a right to sell if the option price (exercise price) is greater than the market price. 20. In a Put option contract, it is said to be "in the money" transaction if the exercise strike price (option price) is lower than the so called market price. 52  FINANCIAL ENVIRONMENT 21. In an option to buy a foreign currency, when the spot market price is lower than the exercise strike price it is said to be "out of the money" transaction. 22. If the option price is equal to the spot market price, it said to be "at the money" whether the option is put or call option. 23. Future market is a market where assets or goods are delivered in the future while the price of the said assets is determined today. 24. If the investor ALEX has P 10,000 cash to invest in highly risky investment, he should invest in bond market rather than stock market to earn more. 25. In a primary stock market transaction, the transfer of capital from seller to investor changes the capital structure of the corporation. 26. In a secondary stock market transaction, the transfer of capital from seller to investor involves the sale of outstanding shares of the corporation, thus, it changes the capital structure of the said corporation. 27. Initial Public Offering is the first time offering of closely held company's stocks to the public. 28. The IPO is classified as primary market transaction or secondary market transaction, wherein the former transaction shows that new stocks were sold to new investors while the latter shows that new stocks were sold to existing stockholders. 29. In a seasoned offering, the additional shares of the company were issued after its first time offering in order to finance its investment and operations. 30. A transfer of securities through an intermediary in which the investors will be holding the securities of the issuing corporation is an indirect transfer through investment bank. 53  FINANCIAL ENVIRONMENT 31. If APOLLO Bank, after knowing the plan of CHUA Corporation to go public, purchased all the latter's shares at a certain price then offered these shares to the public, the transfer is deemed as indirect transfer through underwriter. 32. If APOLINARIO Corp, a life insurance company, purchased all the shares of MANALO Corporation after knowing the plan of the latter to go public then offered its own insurance policy to the public, the transfer is known as indirect transfer through financial intermediary. 33. Capital market involves investment is long term debt securities only such as bonds and notes while stock market is where equities are being sold and traded. 34. Mutual funds are investment companies that pools investment from the public then place these funds in equity security but not in debt security investments. 35. In a Unit Investment Trust Fund (UITF), the investor will buy units of investment from the investment company while in Mutual Fund (MF) the investor will purchase shares of the said investment company. 36. If HENDRY SY invested his P 100,000 in mutual fund of Bee-Dee- Owe while his P 50,000 was invested in UITF of Bee-Pee-Eye, the former investment is regulated by BSP while the latter investment is regulated by SEC. 37. An efficient stock market is where the stock prices are considered to be highly overvalued or undervalued. 38. An undervalued stock will be a "good buy" because it shows that the intrinsic value is lower than the market value. 54  FINANCIAL ENVIRONMENT 39. The stock is undervalued if the perceived value is lower than true value, hence the investors will be indifferent in buying or selling. 40. In efficient market hypothesis, the strong form shows that investors can beat the market with insider information and will earn high returns. 41. In a weak form of efficient market, an investor cannot beat the market by simply analyzing the past performances of the stock. 42. In a semi-strong form of efficient market, not all the available public information is incorporated in the stock prices, Hence, analyzing the published financial reports are significant to beat the market. 43. Intrinsic value, also known as the perceived value, is the price that the willing buyer will bid and willing seller will ask provided that all necessary information about the stock is available. 44. Historically the Philippines had two stock markets but these markets were unified forming the Philippine Stock with six (6). constituent indices. 45. Treasury bonds and corporate bonds are both traded in capital market but with different interest rates. 46. Ceteris paribus, the corporate bond's interest rate is always higher than the interest rate of Treasury bond. 47. Investment in equity securities (stock) and debt securities (bonds) are long term investments but the former is riskier than the latter. 48. Ceteris paribus, investment in stocks is expected to provide higher return than the investment in bonds because the higher the risk, the higher the return. 55  FINANCIAL ENVIRONMENT 49. Low interest rate triggers the firm to issue equity securities (stocks) in the stock market instead of issuing debt securities (bonds) in the bond market. 50. The Initial Public Offering is generally performed by family corporations that are going public through issuance of stocks to the public for the first time in the stock market; however, it may also be performed by publicly listed companies through issuance of corporate bonds for the first time in the bond market. 51. The main product under the secondary market is outstanding shares which are sold by a shareholder to an investor thereby increasing the capital structure of the corporation. 52. Issuing 2 million shares of DMZI new stock to the public is a kind of secondary market transaction. 53. A financial market in which funds are borrowed or loaned for short periods is a capital market. 54. Indirect Transfers through Investment Bankers is a transfer of security particularly shares of stock through an intermediary in which the investors will be holding the securities of the corporation / Business. 55. Investment Banks usually specialize assisting organizations raise capital by "syndicating" or arranging for the sale of the securities offered by the borrower as opposed to Commercial Banks performing general banking services such as depositary, checking, trust and various loan products. "In everything you do, never forget to seek the blessings of the Lord for he has the final answer."-ysb 56  FINANCIAL STATEMENT ANALYSIS CHAPTER 3 FINANCIAL STATEMENT ANALYSIS Corporations, especially those publicly listed companies, are mandated by the Securities and Exchange Commission (S.E.C.) to file their annual Audited Financial Statements. These financial statements are composed of: 1) Statement of Financial Position which is traditionally known as Balance Sheet; 2) Statement of Comprehensive Income also known as Income Statement; 3) Statement of Cash Flows, 4) Statement of Changes in Owner's Equity and 5) Notes to Financial Statements. These aforementioned statements are the primary means to communicate the material financial information to its users regarding the operating performance, profitability and the ability of company to meet its obligations. However, users cannot easily determine the financial status of the company by merely looking at the values stated in the Financial Statements. Thus, there are tools and techniques developed by the financial analysts that helps evaluate the company's performance and conditions. In this chapter, we will explore the following: Different tools and techniques in analyzing the financial statements of the company. The significance and formulas of the different performance measurement ratios that reflects the liquidity, solvency, efficiency and profitability of the company. Inanalyzing the financial statements, financial managers use the following tools and techniques such as: a) Horizontal Analysis, b) Vertical Analysis, c) Financial Ratios and d) DuPont Technique. 59  FINANCIAL STATEMENT ANALYSIS HORIZONTAL ANALYSIS is a method of Horizontal analysis of financial statements comparing the Peso value or amount of the particular line item in the Statement of Financial Position, Statement of Comprehensive Income or Cash Flow Statements over a two or more consecutive accounting period. Moreover, this peso value can be converted into percentages for purposes of comparing the performance of different companies in an industry. Horizontal analysis, which is also known as trend analysis, provides assessment of the significant increase or decrease in these different items in the financial statements. Thus, in performing Horizontal analysis as a technique, we can use the a) Peso value or b) Percentage change for comparison and evaluation of company's performance. % To illustrate, use following Statement of Financial Position of FSA Corporation for the year 2014 and 2015 as shown in table below: TABLE 3-1: FSA Corporation Statement of Financial Position STATEMENT OF FINANCIAL POSITION AS OF DECEMBER 31 (in Millions of Pesos) 2014 2015 2014 ASSET LIABILITIES and SHAREHOLDER'S EQUITY Current Asset (CA) Current Liability(CL) Cash 800 900 Accounts Payable 400 Accounts Receivable 1,300 1,100 Notes Payable 1,600 1,450 700 750 TOTAL CURRENT LIABILITY 2,000 1,900 Inventory TOTAL CURRENT ASSET 2,800 2,750 Non-Current Liability (NCL) Non-Current Asset (NCA) Bonds Payable 3,500 3,700 5,600 4,900 other Long Term Debt 2,400 2,600 Property,Plant and Equipment 2,600 2,350 TOTAL NON-CURRENT LIABILITIES 5,900 6,300 Intangible Asset TOTAL NON-CURRENT ASSET 8,200 7,250 Shareholder's Equity 10000 Common Stocks 500 700 TOTAL ASSETS Retained Earnings 2,600 1,100 TOTAL SHAREHOLDER'S EQUITY 3,100 1,800 TOTAL LIABILITIES AND EQUITY 11,000 10,000 60  FINANCIAL STATEMENT ANALYSIS If the financial manager will perform Horizontal or Trend Analysis on the a) Cash and Cash equivalents item and b) Notes Payable item as shown in the Statement of Financial Positions above, what will be the assessment using: 1) Peso Value or 2) Percentage Change? In using Peso Value for comparison and analysis, the amount of Cash and Cash Equivalents for the year 2015 was increased by P 100 million while the amount of Notes Payable decreased by 150 million. The increase in the amount of cash may signify that there are revenues generated or the inflows of cash are more than outflow. On the other hand, the decrease in Notes Payable may imply that there are payments of obligations made by the FSA corporations. In using Percentage for comparison and analysis, there is a need to convert the Peso value into percentages where in prior period values will serve as the base amount (100%). To calculate the percentage change in values from prior period to the current period, we will use the formula below: Current Year Prior Year Percentage Change = Prior Year If the percentage change resulted to a positive (+), this implies that there is increase in the peso value of the line item subject to evaluation while negative ( - ) percentage means that there is decrease in the peso value. Thus, the change in Cash and Cash Equivalent from P 800 P 900 million in 2015 will be million for the year 2014 to % increase in the value of cash or be reported as 12.5 value of the prior period. reported as 112.5% of the cash 61  FINANCIAL STATEMENT ANALYSIS Percentage Change =P 900 Million - P 800 Million_= 12.5% P 800 Million On the other hand, the change Notes Payable from P 1.6 Billion for the year 2014 to P 1.45 Billion in 2015 will be reported as 9.375% decrease in the value of Notes Payable or be reported as 90.625% of the Notes Payable value of the prior period. Percentage Change =P 1.45 Million- P 1.6 Billion = (- 9.375%) P 1.6 Billion II. VERTICAL ANALYSIS Vertical analysis of financial statements is a technique that involves assessment of the different line items in a single period Financial Statement. These items which are commonly shown in the Financial Statements using their Peso values shall be expressed in percentage of a total amount or the base amount. In this technique, the financial managers can appropriately evaluate the financial information of companies of different sizes because using percentages for comparison provides more useful and relevant conclusions than using the peso values in comparing these companies of different sizes. In addition, Vertical Analysis is performed on the Statement of FinancialPosition (Balance Sheet) where in the base amount in calculating the percentages is Total Assets while the base amount for the Statement of Comprehensive Income (Income Statement) is Net Sales. After using this technique, the financial statements prepared are known as 62  FINANCIAL STATEMENT ANALYSIS common size financial statements. Thus, traditional balance sheet and income statement shall be termed as common size balance sheet and common size income statement, respectively. > To illustrate, let us assume the Statement of Financial Position of FSA Corporation for the year 2015 as shown in table 3-1. In using this technique, the balance sheet items are presented as a proportion of the total assets. Hence, the base amount for purposes of calculating the percentages shall be Total Asset of FSA Corporation amounting to P 10 Billion. Say for example in computing the proportion of Cash and Cash Equivalents to Total Assets, the Peso Value P 900 Million shown intable 3-1 shall be divided by the P10 Billion Peso value to get 9%. The other items presented in percentage form are shown in Table 3-2: Table 3-2: FSA Corporat